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Brexit: What does it mean for the regulation of UK pensions?

Following the vote to 'leave' in the EU referendum on 23 June 2016, the UK voted to exit from the European Union seems to have gathered a lot of momentum. What difference will this make to the UK pensions legal landscape?

The short answer is, on Day One, there may be very little difference. This is because, although much of the regulation of UK pension schemes is shaped by EU legislation, it is not dependent on it. In a post-Brexit UK, absent any repealing or amending legislation, there will still be in existence the UK pensions legislation that enacted the Treaties, Directives and Regulations of the EU.

As a longer term matter though, the impact will depend on the approach taken by the UK legislature to those areas of pensions law which are currently drawn from European legislation. The position will also depend on the extent to which the UK continues to participate in the European Single Market, whether as a European Economic Area (EEA) member or otherwise (as most of the requirements discussed below apply to EEA members). Subject to this, the legislature could, if it so desired, rewrite much of our existing pensions legislation since it would no longer be bound by the constraints of Europe (subject, of course, to the requirements of any subsequent free trade agreement). We look at the impact on occupational pension schemes on such changes to pensions law.

1. Scheme funding and pension protection

The current legislative requirements in Part 3 of the Pensions Act 2004 to fund a private sector defined benefit occupational pension scheme up to the level of its technical provisions is derived from the EU Directive on the activities and supervision of institutions for occupational retirement provision (2003/41/EC), the IORP Directive. It is the IORP Directive that specifies in article 16 that a relevant scheme should,

“have at all times sufficient and appropriate assets to cover the technical provisions in respect of the total range of pension schemes operated”.

The Directive goes on to provide that an actuary should use recognised actuarial methods to calculate the scheme’s technical provisions, taking into account a sufficient level of prudence. Calculations are required annually, or triennially if annual reports showing the relevant adjustments in intervening years are provided. The IORP Directive also provides that Member States could provide for a period of time in which relevant schemes would meet this level of funding (ie the recovery plan period), save in cross-border schemes where the scheme must be immediately fully funded.

The UK had its own legislative scheme funding requirements in place prior to the implementation of the IORP Directive into UK legislation (the Minimum Funding Requirement or MFR) which was much less onerous that the IORP requirements. However, it was widely recognised that the MFR did not provide sufficient protection for member benefits, and there had been political pressure to give member benefits greater protection prior to the IORP Directive. Furthermore, the design of the Part 3 requirements as a “scheme specific” funding regime largely reflected UK government policy and the preceding political debate, rather than being driven by European requirements – if anything, the flexibility inherent in the IORP Directive may partly reflect the influence of the UK on that Directive. On that basis, it seems highly unlikely that the UK would abolish the Part 3 regime or return to the pre-2004 funding regime on a UK exit from the EU, but the possibility would then exist that the fundamentals of the current regime of funding to technical provisions could be revisited in the future.

The fact that the Brexit debate took place at a time when discussions around the IORP II Directive were on-going, is also of interest. The UK Government, sponsors of UK private sector defined benefit occupational pension schemes and other major stakeholders (such as the TUC, CBI and others) expressed discontent with the solvency funding requirements based on a “holistic balance sheet” tabled in the original drafts of the revised Directive. This discontent was in part the reason for the removal of these provisions from subsequent revised versions of the draft Directive. However, we understand that the proposals in respect of the “holistic balance sheet” have merely been shelved – now that a Brexit has materialised, concerns over the imposition of an onerous funding requirement, from Europe at least, are likely to be allayed.

2. Cross-border pension schemes

Cross-border pension schemes (i.e. those with members in more than one EU or EEA Member State) are required to be immediately fully funded under EU (and therefore UK) legislation. Sponsors of UK private sector defined benefit occupational pension schemes have been at pains to avoid being caught by the cross-border rules as a result. Once the UK exits the EU (without remaining a member of the EEA), a scheme would no longer, by virtue of having members in the UK and in one EU or EEA Member State, be subject to the cross-border funding requirements. To this extent, Brexit represents a relaxation of the current cross-border funding regime.

The Pension Protection Fund in the UK satisfies the requirement to establish a pensions “lifeboat”, as set out in the Insolvency Directive (2008/94/EC). An exit from Europe means that the requirement to have the Pension Protection Fund (PPF) in place would no longer exist. However, the creation of the PPF was largely the consequence of a political debate within the UK and resulting UK government policy, rather than being prompted by the imposition of European requirements. Again, it would seem highly unlikely that there would be any political appetite to abolish the PPF or materially reduce the level of protection that it affords to occupational defined benefit pensions.

3. TUPE and Beckmann rights

The automatic transfer principle for employment rights and liabilities under the Transfer of Undertakings (Protection of Employment) Regulations 2006 (TUPE) is derived from the Acquired Rights Directive (2001/23/EC) (ARD). At a high level, it provides for the automatic transfer of employment of employees where there is a business transfer, on the same terms and conditions as existed prior to the transfer. The ARD also provides that the provisions concerning the automatic transfer of employment rights shall not apply to employees' rights to old age, invalidity or survivors’ benefits unless Member States provide otherwise.

The scope of the “pensions exclusion” from the ARD and TUPE has been the subject of numerous cases before the Court of Justice of the European Union (CJEU) and the UK Courts, the most often quoted of which are Beckmann1 and Procter & Gamble v Svenska Cellulosa2. The precise effect of the “pensions exclusion” so far as UK defined benefit pension schemes are concerned, remains debated, and there is a real issue in interpreting the CJEU decisions in a way that is relevant to such schemes. This question is often one of the most difficult UK pension issues on an M&A transaction structured in a manner which engages TUPE legislation. By contrast, it is not generally an issue elsewhere in the EU, for example in Germany where the wording for the “pensions exclusion” was derived.

There is some discontent at the shape of TUPE legislation in general in the UK. From an employment law perspective there has been discussion about the “gold plating” of TUPE in the UK as it applies on outsourcings or service provision changes, whereas this is not required by the ARD itself. In addition, there is frustration at the inability to harmonise terms and conditions of employees post-TUPE transfer – with the special protection afforded to employees who TUPE transfer (compared to those who transfer under a share sale) being questioned.

While a rejection of the automatic transfer principle in the UK seems unlikely, might the UK's exit from the EU pave the way for the UK legislature to take a more radical approach to these issues? While the TUPE regulations were themselves amended in 2014, the final amendments had less impact than certain commentators had previously expected. Could Brexit lead to more fundamental changes therefore to the way in which the automatic transfer principle would operate? And what could this mean for the pensions exclusion?

4. Equality legislation

Two key areas of equality legislation that are particularly relevant to pensions are sex and age discrimination. The UK anti-discrimination legislation in relation to these protected characteristics are drawn from EU legislation (the Treaty on the Functioning of the European Union (2012/C 326/01) (TFEU), and the Framework Directive (2000/78/EC), respectively).

It has been for many years a clearly established principle that pension benefits as between men and women are required to be equal, and that seems very unlikely to be amended even if the UK were to exit the EU. However, there could potentially be greater flexibility in relation to the way in which sex equalisation has to be implemented in relation to pension schemes (as this has been spelt out in case law by the CJEU, initially in the decision of Barber v Guardian Royal Exchange Assurance3 in 1990). Could Brexit, for example, put an end to the headache of needing to equalise GMPs?

Similarly, in the 2011 CJEU decision of Test-Achats4, the Court held that gender based actuarial factors would not be permitted under insurance policies (which are governed by the Council Directive implementing the principle of equal treatment between men and women in the access to and supply of goods and services (2004/113/EC) (the Gender Directive)). This impacts, for example, life annuity contracts. There has been much discussion about potential “overspill” from this decision into the occupational pension scheme arena, which is governed by the equal treatment on grounds of sex principles set out in the TFEU, as mentioned above. Brexit would give flexibility in this regard (although there is no knowing of whether and how that flexibility would be used).

The way in which anti-age discrimination legislation is framed at EU level has caused many difficulties in relation to UK pension schemes (for example, on questions related to the overall scheme design or proposals to undergo benefit change exercises or liability management exercises such as pension increase exchanges). This is because the Framework Directive sets out that Member States may provide that, in certain limited circumstances, occupational pension schemes may benefit from an exclusion to the anti-age discrimination principle.

The problem in practice is that these exceptions are sometimes too narrowly drawn so that it is unclear whether or not a common practice is permitted (for example, under the UK legislation closing a scheme to new members is permitted under an express exemption to the rules, but closing to future accrual is not expressly exempted). Any circumstance that is not expressly permitted must be able to be objectively justified in order to be permitted age discrimination. There is also a concern from the opposite point of view about whether the exceptions in UK legislation are compatible with the underlying EU Directive. The prohibition of age discriminatory practices would clearly continue as a general matter, but the concern about how the exceptions are drawn would fall away. In addition, would the legislature seek to rewrite the way in which the legislation applies (or does not apply, as the case may be) to pensions matters?

A further point is in relation to discrimination on grounds of sexual orientation. In the recent Court of Appeal decision in Walker v Innospec5, the Court focussed in part on the permissibility from an EU law perspective of an exclusion under UK legislation from equal treatment in relation to same sex marriage and civil partners. In the context of the case, the exception provided that the principle of equal treatment on grounds of sexual orientation did not apply in respect of pension rights attributable to service before 5 December 2005.

The Court of Appeal held that the temporal exception was consistent with the Framework Directive because the right of equal treatment on the ground of sexual orientation did not become a fundamental EU principle itself until 3 December 2003 (and this had no relevance in these circumstances until 5 December 2005 when same sex civil partnerships were legalised in the UK).

To the extent that the UK legislature has based its exemption from the principle of equal treatment on EU legislation, Brexit could potentially give cause to re-examine the policy justifications for the exclusion. It seems likely though that the knock on cost implications, particularly for public sector schemes, of full equalisation of all widow and widower benefits (i.e. both in relation to men and women, regardless of whether they are in opposite sex or same sex marriages) which equal treatment could give rise to, or may well prevent any such future legislative change.

5. Investment issues

The UK already had extensive rules for pension scheme investment in place prior to the IORP Directive, partly due to the Robert Maxwell scandal. For example, the obligation on member states in the Directive to impose duties on schemes to invest assets in the best interests of beneficiaries was already widely (but probably misleadingly) viewed as a requirement of English trust law, whilst the requirement to have a statement of investment principles was originally imposed by the Pensions Act 1995. Nonetheless, much of the current legislative framework in relation to pension scheme investments is derived from the IORP Directive, for example the rules on the manner in which trustees must exercise their powers to make investments and the restrictions on the types of assets or transactions that pension funds can invest in or enter into (for example, restrictions on the use of derivatives).

One of the requirements of the IORP Directive is that schemes may not invest more than 5% of the current value of total scheme assets in employer-related investments. Asset backed funding arrangements in particular have to be carefully structured so that they do not fall foul of this rule (as those arrangements typically involve securitising some of the employer’s assets, so that they provide an income stream for the pension scheme). Scottish Limited Partnerships are typically used to structure these arrangements because of the particular way in which these partnerships are considered under the employer-related investment regulations.

There has, however, long been a concern that the use of Scottish Limited Partnerships in this way might not stand the test of time, particularly with increasing scrutiny of such arrangements by the UK Pensions Regulator. Indeed, many asset-backed funding arrangements include in the documentation a “change of law” clause that provides for the documents to be renegotiated if there is a change of law such as to make the arrangement illegal (these were particularly heavily negotiated prior to the Scottish referendum in 2014). Partly, this concern reflects uncertainty as to how the Directive would be interpreted.

The restrictions on employer-related investments were, of course, also introduced in the UK by the Pensions Act 1995, before the Directive was made. However, the inclusion of that restriction in the Directive did give the UK Government and Parliament less flexibility as to what exceptions may apply (various UK exemptions were deleted as a result).

As with other points considered in this briefing, some form of pension investment rules and restrictions will continue to operate after Brexit. However, the precise way in which any new rules are framed will be of great importance to schemes in general given the impact of investment issues on the level of scheme funding, and to existing asset-backed funding arrangements.

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